Learn to invest with Buffett

Chapter 60

Chapter 10 Grasp the arbitrage opportunity and seek prosperity while maintaining stability
Chapter 10 Section 1 Assess arbitrage conditions and take prudent actions

Someone who cannot tell the difference between an elm and an oak can calmly evaluate all offers.

--Warren Buffett
In recent years, most arbitrage operations have involved friendly or hostile takeovers.As the buying frenzy spread, with antitrust challenges all but non-existent and with buying prices often stuck in the red, arbitrage flourished and arbitrageurs reaped the rewards.They don't need special talents to do well.

How to evaluate arbitrage conditions?Buffett believes that the following questions must be answered:
(1) How likely is the expected event to occur?
(2) How long can your cash be locked up?
(3) How likely is it that something better will come along—such as a more competitive M&A offer.

(4) What should be done if the expected event does not happen due to antitrust lawsuits, financial errors, etc.?
In order to help investors further understand the evaluation of arbitrage conditions, Buffett told the story about how Berkshire arbitraged in Akata.

In 1981, Akata agreed to sell the company to a debt-buying firm (KKR, Kolhberg Kravis Robert & Company).At that time, Akata's business projects included forestry industry and printing industry.Additionally, in 1978, the U.S. government acquired more than 4000 hectares of redwood woodland from Akata to expand the boundaries of Redwood National Park.The government paid Akata $9800 million in installments and gave Akata outstanding bonds bearing 6 percent simple interest.The company expressed dissatisfaction with the government's purchase of the land at an unreasonably low price, and the simple interest rate of 6% was too low.In 1981, Akata was valued in its own business and potential government investment. KKR proposed buying Akata shares at $37 per share, plus 2/3 of the government's total payment for Akata.

Buffett researched and analyzed KKR's acquisition of Akata Corporation. KKR's experience raising capital has been quite successful, and if KKR decides to stop the deal, the company will look for other buyers.Akata's board of directors has decided to sell the company.But the more difficult question is, what is the value of the mahogany forest that has been compulsorily expropriated by the government?
In the fall of 1981, Berkshire began to acquire shares of Akata at a price of $33.5 per share.Before November 1981, 11, Berkshire had acquired 30 shares, accounting for about 40% of Akata's shares. In January 5, Akata and KKR signed a formal contract. At the same time, Buffett purchased another 1982 Akata shares at a price close to $1 per share.Despite the complexity of the deal, Buffett is still willing to pay more than KKR's $38 per share for Akata's shares, suggesting he thinks the government's compensation payment for the redwood groves will be worth more than zero.

A few weeks later, deals started to go through.First, despite Buffett's assumption that KKR had difficulty raising capital at the time.At that time, the real estate industry was plummeting, and banks were very cautious in providing loans.Akata's shareholder meeting has been postponed until April.The reason was that KKR couldn't arrange all the financing, so they offered Akata a low price of $4 per share.But they rejected KKR's offer.It wasn't until some time later that Akata accepted bids from other companies to sell the company for $33.50 a share, plus half of potential government lawsuit compensation.Berkshire earned a profit of $37.50 million on its $2290 million investment in Akata, which equates to a 170% annual return, which is quite a satisfying profit.

A few years later, Berkshire finally got its wish to receive the government's installment payment to Akata.During the proceedings the judge appointed two committees, one to determine the value of the redwood groves and the second to determine the appropriate interest rate. In January 1987, the first decision declared the value of the redwood grove at $1 million instead of $2.757 million.The second decision declared that the appropriate rate should be 9790%, not 14%.The court ruled that the government should pay Alkata $6 million.The government continued to appeal and finally decided to pay $6 million. In 5.19, Berkshire received $1988 million, or an additional $1930 per share of Akata.

This is a successful case of Berkshire's arbitrage operation. It is generally believed that Buffett's profit from this investment is far better than he expected, but in fact, before 1989, the arbitrage prospect was not very good.Debt acquisitions triggered excess demand for funds in the market, causing chaos in the market environment.But Buffett acted cautiously when others were dazzled.When the UAL acquisition collapsed, Buffett was withdrawing from the arbitrage trade. With the emergence of convertible special shares, Berkshire could easily escape from the arbitrage trade.

Investment motto:

While most arbitrageurs probably engage in 50 or more trades a year, Buffett only looks for a few major financial deals.He limited himself to open and friendly arbitrage transactions.And refuse to use stocks to engage in speculative transactions that may lead to acceptance or green ticket blackmail.He hasn't calculated his arbitrage performance for years, but Buffett figures that Berkshire's average annual after-tax profit rate is about 25%.

Since arbitrage is often used in place of short-term Treasury bills, Buffett's appetite for trading often fluctuates with Berkshire's cash stock.What's more, he explained, the carry trade saved him from loosening his own stringent long-term bond investing standards.

(End of this chapter)